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Tuesday, May 24, 2016

The Truth About Actuarial Valuations of Pension Plans

I've heard the same comments for years. I've heard that a company loves its actuary, but they can't give you one reason why. I've heard that actuarial work is a commodity and that everyone produces the same numbers, so you might as well go with the lowest bidder. There's more; there's lots more.

I'm here to tell you that it's all wrong and it's wrong now more than ever.

Let's revisit history a little bit. In the beginning (well, not quite the beginning), there was ERISA. And, Congress saw that it was good ... for a while.

ERISA brought us rules and choices. The rules said that plan sponsors had to fund the sum of the annual cost of benefits that were accruing (normal cost) plus a portion of the amount by which the plan was underfunded using some fairly complex formulas. But, those calculations were pretty malleable. In fact, there were many methods by which to calculate those numbers and if you couldn't find the methods to get you the answers you wanted, you could likely talk your actuary into selecting assumptions to get you to those numbers. That's the way the game was played from the mid-70s through the mid-80s.

Then, the rules began to change. Congress saw that corporate tax deductions for funding pensions were a significant drag on the federal budget. So, Congress sought to limit those deductions by bringing in multiple funding regimes. So, was passed the Pension Protection Act of 1987 as part of the Omnibus Budget Reconciliation Act of 1987. And, Congress saw that is was good ... for a while.

Multiple funding regimes theoretically brought multiple choices, but with the 90s came the era of full funding. With the use of high discount rates tied to assumed rates of returns on plan assets, those assets exceeded the calculated liabilities of the plan. More plans than not had no required contributions. Pensions were cheap.

And, then came the perfect storm. Interest rates fell, asset values fell, and Congress had to do something. In 2006, Congress passed another Pension Protection Act (PPA). And, Congress saw that it was good.

But, there was something different about PPA. It severely limited flexibility in calculating the actuarial liabilities of a pension plan. In fact, with very limited exceptions, without any knowledge of the actuarial assumptions being selected, another actuary could fairly well reproduce that calculation of actuarial liabilities (at least within in a few percent).

But, what we have now is a tangled web. There are so many liabilities and percentages. Every single one of them affects the cost of your plan. There is the funding target, the plan termination liability, the liability for purposes of calculating PBGC premiums. There's the FTAP, the AFTAP, and various other funding percentages.

While each individual calculation is simple, getting to the correct answer is not.

And, that's why your choice of actuary for your plan is actually far more important today than it used to be.

Suppose I told you that your actuary's lack of attention to your plan as compared to the rules was costing you more money annually than you pay in actuarial fees.

Suppose I told you that your actuary's not focusing on your business's cash flow needs was forcing you to borrow unnecessarily.

Suppose I told you that that renegotiation of a loan covenant that you just went through because your pension plan had too low a funded percentage could have been avoided.

The scary thing is that I have told companies all of those things. We're in an era now where calculation is easy, but strategy is difficult. In fact, more plans than not are using a suboptimal strategy. Don't you need to know if you are spending more money than you need to or if you are spending it inefficiently?

Disclaimer

The opinions expressed in this blog are not those of anyone but the author of the particular post or comment. Nothing in it is to be construed as the opinion of any employer unless specifically disclosed as such.

The express intent of this blog is to provide no investment advice of any type. While asset allocation and theory may be discussed in a research or academic context, no advice as to specific investments or strategies is intended or permitted.